After the COVID-19 pandemic, when working at home became a major trend for office workers, office properties across the U.S. saw occupancy rates plunge, along with revenues and building values. Higher interest rates made financing properties more expensive, and, with more than $700 billion in outstanding commercial mortgages coming due in 2023, pundits predicted a wave of foreclosures, continuing into 2024.

According to local stakeholders, the Twin Cities office market did not see such a wave, even as office vacancies in Minneapolis and St. Paul downtown sub-markets reached a new high.

There have been a few foreclosure sales in the local market. For example, Capella Tower in downtown Minneapolis was repossessed by lender Met Life, after a mortgage default and a failed attempt to sell the under-utilized office building.

"One reason we haven't seen as much activity by these (distressed property) funds - although I have seen more activity in other cities" - is that these situations take longer to play out than one would think," said real estate attorney Brad Williams, a partner with Dorsey & Whitney. To some degree, it's "a combination of borrowers and lenders not wanting to face reality. And so once they do start to face it, it's a process that takes time.

"With interest rates not as low as the market thought they would be, some situations have been dragging on, to the point where the parties can't reach consummation of a transaction, in which they know what the sale price will be," Williams said. For example, the Forum office towers in Minneapolis. "There was a (distressed) fund involved in that but the opportunity for that fund to invest in those buildings didn't happen until there was a foreclosure sale," Williams said.

Also, as an added factor for funds being willing to buy distressed properties through a foreclosure sale, "they will be considering the redemption rate the borrower has and whether that will pose a risk," he explained. "Borrowers on a mortgage have the right of redemption; typically, the borrower has six months to redeem and buy the property back from the purchaser -- a lender or fund or third-party purchaser. If they don't know with certainly whether a buyer is going to redeem within six months, they will have to wait six months to find out if they have the title and can start doing renovations and market the property."

One reason for a lack of buying and selling activity locally is a lack of interest from outside the market, said John McCarthy, a vice president with United Properties. "When you are dealing with distressed property there are so many moving parts; it's so different from a traditional transaction," McCarthy said." I don't believe funds in places like New York City can buy those as they do traditional property. They are too complicated for the funds. With a value-added opportunity to redo a property, you need local expertise."

He's also seeing some lenders doing short-term extensions with owners and hoping that lower interest rates will become a reality. "That is partly delaying some of the transactions, with owners hanging on."

Last year, Philadelphia-based law firm Ballard Spahr formed a new division in its Minneapolis office to handle distressed property matters. Bill Wassweiler, who heads the group, said he has seen less litigation than happened in previous real estate downturns. "We're not seeing as much litigation with more voluntary sales, versus foreclosures."

One change from earlier this year: "What we're seeing now in the Twin Cities is that lenders are not as interested in providing extensions. They are moving forward with foreclosures and remedies as the preferred path over trying to restructure debt with existing borrowers, because there is still a lot of uncertainty in market. just going forward with short sales," Wassweiler said.

With uncertainty about how far interest rates will drop in 2025, while there is more optimism, I think it could be very similar to 2024, not slowing activity, but not accelerating, either. If there were to be some programs to provide some incentives - such as conversion to residential space - that might spur more activity. But, overall, I think it is going to be more of the same," Williams said.

Another reason that it may be taking longer for funds to invest in properties is prices that may be higher than expected: "what lenders are willing to do with the situation, and the impact of lenders purchasing at foreclosure, or taking a deed in lieu of foreclosure.

For example, if a lender credit bids its outstanding loan amount at a foreclosure sale, or accepts a deed in lieu of foreclosure, "this likely means the lender is willing to own the property for some period of time, with a view toward selling the property at a better price than would have been realized in a sale to a third party," Williams said. "As a result, fund investors are not presented with the distressed price purchase opportunity they are looking for.

"I have seen this happen on several occasions locally over the past few years; in most of these cases, the lenders continue to own the properties and are not ready to sell yet. The situations where the lender lets the property sell at foreclosure to a third party for a low price (e.g., the Forum Towers), or allows the borrower to do a discounted pay off (DPO or "short sale"), are the types of situations the fund investors are looking for, rather than the situations where the lender is the purchaser at foreclosure (by credit bidding its outstanding loan amount), or takes a deed in lieu," Williams said.

With the residual effects of COVID hanging on, "a lot of companies are still trying to right-size their real estate footprints," McCarthy said.

"What is unknown is: based on what we have learned over the last few years, how are we going to use office space differently?"